4/28/2009 @ 5:15PM

Wooing And Choosing The Right Backer

Funding hasn’t been harder to come by in decades, and throngs of deserving entrepreneurs are downright starved for it. That’s where angel investors–loosely gathered groups of well-heeled individuals with an eye toward the juicy returns that can come from investing in early stage companies–come in.

Not that you should jump at any angel willing to scratch out a check. Their deep pockets notwithstanding, some angels are more intractable and demanding than others–even while bringing less to the table in terms of expertise and guidance. That’s why entrepreneurs should know what they’re getting into before betting their fortunes on one of these benefactors.

Some cold water first. Dismiss the notion that the choice of an angel is totally up to you–ultimately (and especially in this environment), angel investors choose business owners. Also, try to remember that desperation–the kind that kicks in when your young company’s very survival is at stake–chokes off all vestiges of sanity.

Those parameters established, let’s look at how this selection process should work when done right.

The first step is preparation. This involves knowing how to whip up excitement about your prospects. The best way to do that is by sequencing your presentation so it progressively builds your story. Time-tested tools include:

–A 15 to 30 second verbal summary covering the essence of your business proposition, also called an “elevator pitch.”

–An executive summary that captures, in not much more than a page, the one-of-a-kind investment opportunity you are offering.

–A clean, clear Power Point presentation, delivered in no more than 10 minutes, that answers questions like “Who are you?”, “Why are you special?”, “How will you succeed?”, “What do you need to ensure success (besides just money)?” and “When and how much will I, as the investor, get paid back?”

–A comprehensive business plan that expands on the questions in your Power Point presentation but still comes in at under 25 pages. (For more on how to stump for capital, check out the upcoming third annual Forbes.com Boost Your Business competition.)

Preparation also involves understanding a particular angel’s investing style. Most angels prefer to spread their risk among a consortium of investors. These groups are generally only interested in companies that have exceptional growth potential–generally, companies that have the potential to bloom into $100 million (sales) enterprises in roughly five years. If that’s not you, then you might be better off courting a so-called affinity angel–someone looking for a company that’s focused on a market niche near and dear to their heart. Often, these investors are attracted to start-ups with more of a social responsibility bent.

Where to find your angel? These days, many have their own Web sites, and plenty tend to advertise locally. One important rule of thumb: Avoid those located further than one hour away by either car or plane; like venture capitalists, angels prefer to invest in local companies so that they can sit on their boards and provide close supervision.

Assuming you roust a few competing takers (a nice problem to have right now), and assuming you haven’t succumbed to the thrill of finding a deep and willing pocket, there’s a bit more due diligence that remains. Make sure you:

–Ask about the angel’s track record in getting follow-on investors (such as VCs). Remember that most angel investments range from $500,000 to $1.5 million–still leaving you perhaps many millions short of what you’ll ultimately need to hit your growth targets. That additional capital surely won’t come from angels.

–Confirm the angel is an “accredited” investor. This is a precise legal term that identifies investors who (at least in theory) grasp the risks involved. It thus limits their ability to sue you if things should go awry. Be sure to consult with a lawyer on the necessary paperwork.

–Choose an angel with genuine knowledge of and connections within your industry, which often prove as or more valuable than their money.

–Don’t give away the store too fast. Put another way, don’t accept more money than you need to accomplish your next major milestone. Reason: If you expect hockey-stick style sales growth, then your company’s valuation will follow.

Say you need $500,000 to finish a working prototype and another $1 million to set up your distribution channels. In that case, don’t ask for the entire $1.5 million up front; if you do, the value of your company will be based on the fact that you (currently) have no hard proof that a working prototype can be made, much less that anyone would want to distribute it. By asking for just the $500,000 first, you can give away a small slice of equity, at that lower valuation, leaving more upside for you down the road.

Finally, watch out for red flags in the funding contract (also called a term sheet). You may not be able to do anything about them, but you do need to fully understand their implications. Common traps include:

–Management substitution clauses. These allow an angel to replace any part of the management team he deems necessary if the current team fails to meet certain milestones.

–Optioned ownership. Say an angel agrees to buy 12% of your company; you might think that leaves you with 88%, but those slices may not be considered equal in the eyes of an angel. The logic: An angel’s slice is based on an actual valuation, and thus is fully justified, while yours vests over time. According to the contract, you might own only 20% today while the remaining 68% would be set aside as an option “yet to be earned.” Avoid these pesky–and pernicious–clauses.

–Board positions. Under the guise of good corporate governance, many angels (and VCs) will try to put certain outsiders on the board. Never forget that the board–not you–ultimately controls the company.

If the deck sounds stacked against you, it’s because in many respects, it is. However, when it comes to raising money, if you know the rules of the game, you should be able to play it better than most.

Jim Casparie is chief executive of the Venture Alliance, a leading provider of advisory services to entrepreneurs. Among its services, TVA rates the potential fundability of young companies looking for investment capital. He can be reached at jcasparie@tvausa.com.